Thursday, February 26, 2009

Why house prices are going to get even more hammered

Friend sent link to this post about house prices and price/ income ratios in the UK. I've a mildly professional interest in this issue.

I agree with the main thrust, that price to income ratios are out of whack and must revert to a lower number before house prices will stabilize.

But we get a little deeper understanding when we ask the question: How did this ratio get so far from norms in the first place?

The answer, as we all know now, is that lax lending practices did it. I'll speak in oversimplification, to make the point. Going to ignore taxes, speak of drastic shifts as examples, for illustrative purposes.

If the lender thinks home values will grow indefinitely, the lender will be more likely to lend at high loan to value ratios, where the owner has no equity interest in the home, save its future appreciation. So suddenly, because the lending criteria relax, consumers can afford as much house as they can afford a payment stream. This allows home buyers to enter the market not when they have saved enough for a down payment, but when they have an income stream that can afford the mortgage payment. So demand surges, as this lets more buyers in. One no longer has to wait and save, one can buy today! No money down! No credit? No problem!

And now the lenders have tightened. They want to see down payments as a hedge against their own risk of the property's value declining. The bank wants to own the 80% of value yet to be paid for, not the first 20% of value the consumer owns. Adding the downpayment requirements pushes the devaluation risk to the consumer, not the bank. Value declines, it's the owner's stake, not the bank's that gets hit.

So now someone who has the income to afford the payments, but no down payment can't get the loan. And they're forced to sit on the sidelines of the market until they've set aside enough cash to re-enter the market. So no matter how low the mortgage interest rates go, buyers still can't enter the market without saving up money.

I ran some numbers, to get a feel for this. I kept it simple, and rounded here and there.

Assuming a household income of 100K (high, no matter what the currency or location, save Zimbabwe) and a safe payment burden of 35% of monthly pre-tax income, a mortgage interest rate of 5%, term of 30 years, fixed rate, we can afford about 550K of loan.

In a 0 down payment world, we can buy 550K of house. (Value to income = 5.5)

In a 20% down world, to get the 550K of loan, we must put down 137K, but then we can buy 688K of house. (Value to income = 6.8!)

Trouble is, if we have no down payment, we can buy the 550K in the first scenario, but can't buy anything in the second. And if savings interest is 2% and we save half the mortgage payment by renting, it'll take 7 years to come up with the down payment for scenario 2. So the change in lending practice took today's buyer out of the market until 7 years from now. Way to kill demand, lending institutions!

And even if we set our sights on a 300K property (value to income = 3.0, historical norm), where we can well afford the 1272 monthly payment, we still must come up with 60K down, in a 20% world, which would take us 3 years to save, with the previous assumptions. So even when values get back in line with incomes, people without down payments are still out of the market until they've saved enough to enter. So the time to rebound isn't just a function of house prices and loan rates, (payment affordability) but also a function of time and savings rates (down payment affordability).

Now this is an oversimplification, but it makes the point: Yes, people can't afford these house prices, but also, they can no longer buy, even as prices decline, because they must first save (or at least have to save more now than they did a year or so ago) to enter the market.

So if government really wants to support house prices (which I think is a terrible idea) they need to get buyers in the market by helping with the down payment/ value decline risk part of the problem. Match a down payment, take an equity stake in the property, and take on the risk of decline. Stipulate that consumer's equity gets wiped out first if sold for loss or repossessed, then government, then bank. Government gets return on its portion of equity, consumer on his, when property is sold. Government can claim its portion through taxes due at time of sale.

Again, I don't think government should get involved in price targeting, unless we want massive inflation, which seems to be the only solution to our current mess. But if they want to attack the problem, they should go after the part that's holding back demand: Suddenly tightened (reverting to reasonable) lending standards, and the challenge of meeting these standards with the up front payments.